What Inventories Tell Us about Aggregate Fluctuations -- A Tractable Approach to (S,s) Policies

We estimate a DSGE model with (S,s) inventory policies. We find that (i) taking
inventories into account can significantly improve the empirical fit of DSGE models
in matching the standard business-cycle moments (in addition to explaining inventory
fluctuations); (ii) (S,s) inventory policies can significantly amplify aggregate output
fluctuations, in contrast to the findings of the recent general-equilibrium inventory
literature; and (iii) aggregate demand shocks become more important than technology
shocks in explaining the business cycle once inventories are incorporated into the
model. An independent contribution of our paper is that we develop a solution method
for analytically solving (S,s) inventory policies in general-equilibrium models with
heterogeneous firms and a large aggregate state space, and we illustrate how standard
log-linearization methods can be used to solve various versions of our inventory model,
generate impulse response functions, and estimate the model’s deep structural parameters.